Archive for April, 2011
The Brighter Side of Capital Losses
Friday, April 1st, 2011
There’s opportunity in that red ink
Capital losses are an inevitable part of investing, once you stray beyond federally insured investments, such as bank savings accounts and certificates of deposit. The good news is that losses can be used to lower your tax liability. They also give you an opportunity to reposition your portfolio.
Understand the basics
A capital loss occurs when you sell a security for less than your “basis,” generally the original purchase price. You can use capital losses to offset any capital gains you realize in that same tax year.
When your capital losses exceed your capital gains, you can use up to $3,000 annually to offset wages, interest and other ordinary income. (The limit is $1,500 for married people who file separately.) If your capital losses exceed these limits, you can carry the remainder forward to future years until it’s used up.
Watch out for the wash sale rule
Years ago, investors realized it would often be beneficial to sell a security to book a capital loss for a given tax year and then — if they still liked the security’s prospects — buy it back immediately. To counter this strategy, the IRS imposed the wash sale rule, which disallows losses in situations where an investor sells a security and then buys the same or “substantially identical” security within 30 days of the sale, before or after.
Waiting 30 days to repurchase a security you’ve sold might be fine in some situations, but there will undoubtedly be times when you’d rather not be forced to sit on the sidelines for a month. Likewise, you might hesitate to double up on a position in which you have a loss and then wait 31 days to sell the original stake — a strategy that technically avoids a wash sale violation because the purchase occurs more than 30 days before the sale.
Take a fresh look at your losers
Fortunately, there’s another alternative. With a little research, you might be able to identify a security you like just as well as, or better than, the old one. Let’s assume, you own stock in a networking equipment company that has lost value since you purchased it. After researching the industry, you discover that the company’s chief competitor is actually more attractively valued and has better growth prospects.
Your solution is now simple and straightforward — you simultaneously sell the stock you own at a loss and buy the competitor’s stock, thereby avoiding violation of the “same or substantially identical” provision of the wash sale rule. In the process, you’ve added to your portfolio a stock you believe has more potential.
The same strategy can be applied to mutual funds. In that case, your financial advisor can help you identify a mutual fund or exchange-traded fund with a similar investment strategy and size.
Actively managed funds can be harder to replicate than index funds, especially if you like a particular manager. Remember, though, whatever replacement you come up with doesn’t have to be a long-term solution. It can essentially be a placeholder for 30 days, a way of retaining a position in the market in case a significant advance should occur. If you prefer your original fund, you can always buy it back after the 30-day window expires.
Pay attention to the details
If you purchased shares of a security at different times, be sure to give some thought to which lot can be sold most advantageously. The IRS allows investors to choose among several different methods of designating lots when selling securities, and those methods sometimes produce radically different results.
When buying mutual funds, it pays to know when the next capital gains distribution will occur and how large it will be. If the distribution is sufficiently large and the date is imminent (they often occur in December), you might want to delay your purchase until afterward to avoid incurring a sizable tax liability. Your tax advisor can help you sort through your various options.
Ease the sting
Losses are an unpleasant fact of investing. But with a proactive attitude and careful planning, you might be able to use a loss to lower your taxes and strengthen your portfolio — which can go a long way toward easing the loss’s sting. Before taking any action, always discuss your options with your financial advisor.
SIDEBAR: Congress extends the 15% tax rate on long-term capital gains
Near the end of 2010, Congress passed legislation extending the favorable tax rates on capital gains instituted in 2003. That means a 15% rate on long-term capital gains for taxpayers in higher tax brackets and 0% for those in the 10% and 15% brackets. These rates will apply to both the 2011 and 2012 tax years.
With rates now scheduled to stay low through 2012, there’s no immediate pressure to lock in capital gains to avoid paying higher taxes later. However, investors will definitely want to see which way the political winds are blowing in the second half of 2012 and fine tune a strategy that reflects any likely changes in tax policy.
At any rate, tax considerations should remain only one factor — and not necessarily the most important one — in the decision to buy or sell a security or mutual fund. Also consider your analysis of the security or mutual fund’s prospects and how it fits in with your broader asset allocation goals, as well as your investment time horizon.
Courtesy of PDI Global. © 2011